November 1, 2013
Investment Newsletter for the end of October, 2013
This month continued strong. The Dow increased from 15,130 to 15,546 (a 2.75% increase), the S&P 500 increased from 1,682 to 1,757 (a 4.46% increase), and the Russell 2000 Value Index increased from 1,074 to 1,100 (a 2.42% increase). The market is near its all-time high.
This month one of clients asked me to discuss bonds. I realized then that I had often written about portfolio strategy, the markets, risk, taxes, etc. However, I have never discussed bonds. Thank-you Mary.
At its simplest, a bond is a debt. A company or a government borrows money for some purpose from investors. The investor can and often will sell these rights to receive future money to another investor. The key points.
1. Face Value. The face value is the original amount borrowed. It may not be what you paid. You may have bought the bond from someone else. That person may have sold the bond to you at a profit or at a loss. The face value is however exactly what the company or government will repay at maturity. When that payoff happens, you may have a profit or a loss.
2. Duration. How long before the maturity date. Very short term bonds can mature in only a few more months. Very long term bonds might be 30 years. If the bond matures later today as an extreme example, the price this morning will be virtually the same as the face value this afternoon. There will be no fluctuation in price. If the bond does not mature for ten years, the price can still bounce around like a teenager’s ideal roller coaster.
3. Interest Rate. The company or government pays interest to the investor. The amount depends on the contract interest rate, often called stated yield. It is paid according to a schedule, often every half year. I am ignoring here bonds that are originally sold with a deep discount and then do not pay interest. The interest rate you actually get depends on the payment amount and what you paid for the bond. If you buy a bond for $1,000 and then receive $100 interest, your actual yield is 10%. Its stated yield may be 5% (face value of bond is $2,000), 20% (face value of bond is $500), etc. In general, as market interest rates go up, bond prices go down and vice versa.
4. Quality. Bonds can be secured against real estate, revenue from a project, the full faith and credit of the issuer, or unsecured. The better the security, the safer the bond. The city of Detroit is in bankruptcy. Would you rather have an unsecured bond or a bond with a first mortgage on the real estate used for parking lots? The issuer is also rated by several rating services (Moody’s, S&P, etc) as to their financial health. These ratings are usually letter based. Triple A, etc. Detroit’s rating is very poor. It is very likely that the unsecured bond holders will lose their money. Therefore, the bonds are being sold for a tiny fraction of what was originally paid.
Bonds are not safe. They fluctuate in price based on how long before maturity, quality of the issuer, security, and changes in interest rate. I use only short term bonds to minimize this fluctuation. I want the risk to be in the equities not the bonds. Equity risk has a fatter reward.